While lots of investors have turned incredibly bullish on the stock market lately, economists have continued to issue ominous reports about the fact that Europe’s crisis is not even close to ending.
We’ve been arguing much the same thing for a long time now, and a handful of developments today—plus some commentary from one of our favourite economists, Citi’s Willem Buiter—only give us more faith that the time is nigh for a reversal.
First, Buiter remarked this morning in an interview with Bloomberg Radio, “Spain is the key country about which we’re most worried. It’s really moved to the wrong side of the spectrum and it’s now at greater risk of restructuring than ever before.“
Last fall, investors considered Spain to be the most stable of the troubled PIIGS, with a debt-to-GDP ratio that hit just 68.5 per cent this year. However, with the pressure off sovereign borrowing, banks are now the institutions more at risk. Although they have loads of free cash after the European Central Bank performed two massive liquidity operations, on the whole European banks probably need to more than double the money they borrowed from the ECB with financing from the markets in order to stay afloat through 2013.
Spain’s banking system is in the gutter. Today the Bank of Spain released data showing that banks’ bad loans rose to 7.9 per cent of their portfolios on average in January—the highest percentage of bad bank loans since August 1984, just as Spain’s new democratic government was struggling to maintain stability in the wake of the Franco regime.
This trend—which is likely to continue—puts Spanish banks in a precarious position. According to Reuters, construction and property loans totaled €396.8 billion ($523.7 billion), or 37 per cent of nominal GDP at the end of 2011. Mortgage loans comprised a full 57 per cent of GDP, though a much smaller percentage of these were described as “doubtful.”
This could add to pressures already building in Portugal, which investors generally believe will be forced to restructure its debt in 2013 without some serious eurozone policy change. Spanish banks would be on the front line of losses in a Portuguese default, as geography has sealed economic ties between the two countries.
This might all be under control if EU leaders were making substantial progress towards a credible solution to the crisis, however observers generally agree that nothing has really changed. EU officials continue to argue about increasing the firepower of the European bailout funds, with little to show for their efforts. This lack of momentum isn’t likely to change anytime soon.
Buiter remarked today:
“When the gun of the markets is no longer at the temple of the banks or the governments in the form of extreme difficulty funding themselves, the efforts for recapitalization in the case of banks, deleveraging for governments tend to slacken off…
“The odds of somebody or some institution with enough political weight—enough political gravitas—to do what needs doing in terms of liquidity support and at the same time insist on the restructuring of the obviously insolvent sovereigns and the restructuring and recapitalization of the many insolvent banks in Europe—the odds of that happening in the next year or so are very very low.”
So has the momentum finally cracked?
In the markets, we’re still not seeing the major moves that we saw earlier in the year, although the DAX is setting up its first week of losses in a month, down 1.17% three days in.
Most importantly, however, optimism has definitely vanished about Spain. Its new government is not working miracles (despite passing a few reforms) and the country’s banking sector looks like it’s falling into an even deeper hole.
That has been reflected in bond yields—Spain’s 10-year government bond rose 17.5 basis points today to end at 5.41%. Italy’s 10-year government bond yield was also back on the rise, up 10 basis points to 5.00%.
While we cannot be certain that a market turnaround is going to happen tomorrow, what we can be certain of is that the headlines are just going to get worse. Investor expectations have caught up with the economic data coming out of the eurozone, and with no more LTROs to go—and continued divisions over the still probably ineffective euro bailout funds—we have little choice but to affirm our pessimistic outlook on Europe. One shock could be all we need to restart the downward spiral.
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